Too Much Risk?

The economy may be downshifting, but you wouldn't know it by looking at the commercial real estate investment market.

The economy may be downshifting, but you wouldn’t know it by looking at the commercial real estate investment market, where Real Capital Analytics reports that the dollar volume of sales through the first four months of this year is 87 percent ahead of the same period in 2010. The rule-of-thumb forecast put forward by analysts at the end of last year was for a 50 percent increase in 2011, so the market is well-ahead of projections through the first one-third of this year.

Sales of core assets remain strong, while investors are gradually embracing riskier assets – properties in selected secondary markets, properties with less-stable rent rolls, a block or two off “Main and Main,” etc. Although many properties remain in distress, banks loosened their lending standards in the first quarter of 2011 following 20 consecutive quarters of tightening, and CMBS lending is expected to reach $40 to $50 billion this year compared with $12 billion last year and $3 billion in 2009. The 10-year Treasury note is again flirting with the 3 percent threshold, having moved lower by about 50 basis points in the past six weeks. This surprised many bond investors who thought yields would be headed higher as the economy gained momentum. The trouble with that scenario, however, is that the economy has lost momentum so far this year with first quarter GDP mired at a disappointing 1.8 percent at a seasonally adjusted annualized rate, down from the fourth quarter reading of 3.1 percent.

While low interest rates are a powerful stimulant for investor demand, are investors getting too aggressive? If the economy continues to weaken, leasing demand for commercial properties will weaken in tandem. Thus, investors will find it harder to make riskier assets pencil out. The Labor Department’s Employment Situation report for May, due out on Friday, will help answer this question. A sub-150,000 reading (less than 150,000 net new payroll jobs added in May) will confirm the slowdown evidenced by other recent indicators. Conversely, a print of 225,000 or greater will suggest that employers are confident enough in their order books to keep adding capacity through this soft patch, which would help keep the leasing market momentum going.

For the time being, the outlook is for more of the same: sluggish economic growth and low interest rates. Investors will gradually broaden their target parameters, taking on risk in bite-sized increments while keeping a wary eye on the steady flow of economic indicators.